The story of 2026 so far has to be the Iran war and the fallout from it. At the top of the list is the spike markets have seen in oil and gasoline prices, with the former hitting levels above $100 and the latter rising almost 100% from the 5-year lows hit in late December of $1.70 to a recent level of $3.30. With the move higher in oil and all other related commodities for which oil is an input, the concern for many investors has been the impact of high oil prices on the U.S. economy, since there are both long (Iran revolution-driven price spike), medium (China demand-led spike before 2008) and short-term memories (Ukraine war/Russian sanction-led spikes). The most recent spike just a few years ago coincided with inflation at levels most had not seen in their lives, much less in their investing careers. 

For the rates markets, there is no doubt that the economy, both growth and inflation, matter immensely to the direction of rates. With a dual mandate that covers both growth (full employment) and inflation (stable prices), the FOMC weighs the impact of events on both measures when making its decisions. Over the last few years, both growth (GDP) and inflation (CPI) have been drifting lower, giving a very benign backdrop in which the FOMC was comfortably able to lower rates by 175 basis points. As the 2-year yield is the market’s expectation of what the FOMC will do over the next 2 years, rates came lower as the economic data did, anticipating the easing bias of the FOMC. However, recently, 2-year yields have spiked from 3.5% to almost 3.9%, even though markets are yet to see any impact on the official GDP or CPI data. Is the market anticipating a bigger spike in CPI in the coming months? Is this the most important factor?

If I compare the expectations for rate moves by the FOMC as priced into the Fed Funds futures markets, I can see in the top chart that there are essentially no rate moves priced into the futures curve for the entirety of 2026. This stands out from the easing bias that was priced into the same futures curve only 1 month ago (bottom) where over 2 cuts were priced into the market for this same period. In the last month, therefore, more than 2 rate cuts for 2026 have been priced out. Given this, the market is clearly more focused on the inflation impacts of the movement in oil and gas than any growth impacts from commodity movement. Does this make sense?

I recently came across a good study of the impacts of energy shocks on the economy by Barry Knapp at Ironsides Macro. In this note, he makes the point that oil shocks are likely demand-negative and not inflationary. This is because the high prices crowd out consumer spending in classic stagflationary patterns, meaning that the high prices destroy demand for oil, gasoline and goods that are impacted by the commodity inputs. His views are corroborated by National Bureau of Economic Research (NBER) reports that discuss how previous oil shocks have preempted recessions in the U.S. economy. With this as a backdrop, should the rates market be more worried about falling growth than higher inflation? It appears it should be and this may be an opportunity for rates traders. 

The price action of the June 2-Year Treasury Note futures are telling. Prices have fallen sharply over the past month from a high of 104.50 to a low near 103. However, there are some positives to the recent chart. First, note that on the return to the lows in price in the last week, the RSI has moved higher in a clear negative divergence which would indicate that prices could head higher in the coming weeks. Second, the moving average convergence/divergence (MACD) is turning higher and about to cross, which suggests a change in trend from the weaker price action to a more positive trend. While prices are still down sharply for the past month, these two signs suggest higher prices may be in order in the coming weeks. 

The market appears to be mispricing the 2-Year Treasury futures with a focus more on the inflationary impacts of higher commodity prices, taking rate cuts out of the curve, than the typical recessionary impacts that come from energy price shocks. Recent price action has given signs that the market may be changing its mind and starting to form a bottom with eyes toward higher future prices. The option market shows signs of a panic in terms of volatility and skew as traders rushed to buy downside hedges to protect against the unforeseen fall in futures prices. If futures start to move lower, will I see an unwind of this move in both absolute and relative terms? That may be likely. 

Putting this together, it looks like a great opportunity to sell puts and buy calls or sell skew as the way to implement long ideas. Skew is at levels I have not seen in many years. Looking at the relative strikes that simply selling skew gives, the upside strike may be a bit out of many traders’ targets, however. In addition, with volatility high on an absolute sense, traders may not want to be net long volatility via long calls if futures move higher and I get a volatility crush. The way to take advantage of steep skew, be a net seller of volatility and move the strikes closer to current futures is to sell a put and use the proceeds to buy a call spread. This trade allows the trader to participate more quickly in upside moves, is net short vega for an impending vol crush and can be done for essentially zero cost, giving tremendous leverage to a move higher.  It may seem uncomfortable to have open-ended risk and capped opportunity, which is fair. However, on the downside of futures, from these levels, the market would need to price in aggressive rate hikes for the option to end up in the money. With a change in FOMC leadership coming and a shift to a move dovish FOMC Chair potentially, this does not seem likely. On the upside, it might be hard to see futures get to levels that price in more rate cuts than they had a month ago by the June expiration. June is a good time to put this trade on because it gives the market some time to sort through the confusing headlines from the war, and see the impact on economic data. This all lines up to sell June (TUM6) 103.25 puts and buy the 103.75-104.50 call spread for zero cost. 

In the uncertainty around exogenous shocks markets are seeing right now, traders often focus on the risks initially. However, there can also be opportunities. This might be one of those times when a very interesting opportunity is presenting itself in the market. 

Good luck trading!

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